Economic Incentives Are Key to Driving Sustainability at Scale

When it comes to mobilizing the economy for climate action, most recent progress has been incremental. To come close to achieving the goals of the Paris Agreement, the pace and scale of change must be much more radical. The scaling up we need is not simply a matter of dialing up what we have already begun. What we now need is qualitatively different, and today’s approach won’t get us there.

Merely strengthening disclosure requirements on climate-related data and information could increase regulatory burdens without having a significant productive impact. Regulation needs to be partnered with industrial strategy to create the commercial demand for climate action at scale and for the sustainable finance that is increasingly available. Japan is seeking to do this with a balanced mix of sticks and carrots that is in marked contrast to the approaches of both the United States (mostly carrots) and the European Union (mostly sticks).

Today we expect companies to act on climate change without a financial case for doing so. Their nonfinancial rationales might be to do the morally right thing, to satisfy the ESG (environmental, social, and governance) interests of investors, to instill pride and a sense of commitment among workers, or to keep their options open in the face of uncertainty. These are all sound motivations, but they rarely add up to a solid financial case in which cash investments predictably generate surplus cash returns. As a result, they drive incremental commitments but can’t drive action at scale.

Take, for example, the steel industry, which currently accounts for around 8% of global greenhouse gas emissions. There are multiple technological approaches to decarbonizing steel production, but they are all difficult, speculative, and hugely expensive. As Japan’s Ministry of Economy, Trade, and Industry (METI) observes in its technology road map for the iron and steel industry, “Replacing the existing process with a new one … will require a huge amount of capital investment, resulting in large capital and operating costs. But these additional costs are only for decarbonization and contribute neither to improving the performance of steel nor increasing its productivity.”

In Europe, the “green premium” for low-carbon steel is expected to be above 250 euros ($265) per ton — a premium of upward of 25% on today’s cost. How many customers would choose to pay this added cost for a product that offers no improvement in performance? Some carmakers and construction companies will pay a bit more for the ESG benefit of using green steel, but they can’t afford to pay much because the consumers at the end of the value chain are not choosing to pay more for green steel. And if customers won’t choose to pay the premium, how can the steelmakers afford the huge investment required? The availability of sustainable finance doesn’t solve that problem if steelmakers have no financial case for making the investment.

Driving climate action at the scale that is needed will require more than nonfinancial incentives for businesses. A reliance on such incentives will limit us to nonmaterial, incremental outcomes and also leave the whole climate effort vulnerable to changes in sentiment — a real risk we’re already seeing in the backlash against ESG in the United States. For material, transformational outcomes, companies need financial incentives to act, with financial returns that justify the costs and risks involved. That is the only way that enough companies will choose to invest at scale.

Creating Demand for Sustainable Finance

Where will these financial incentives come from? Today, to shape the availability and focus of sustainable finance, we use scenarios for how different industries need to transition. The International Energy Agency, the Transition Pathway Initiative, the Science-Based Targets initiative, the Glasgow Financial Alliance for Net Zero, and others all set out such sectoral pathways. These scenarios illustrate what is needed, but they don’t make it happen. They are descriptive, not prescriptive. Using these scenarios, we can see what changes an industry needs to make and what an optimal path might be — but describing this path does not move an industry along it.

The challenge is not about finding the money. The supply of sustainable finance is impressive. The challenge is to create the demand for that finance, in step with the growing supply. Today, providers of sustainable finance lament that take-up of the money they have to offer is low because potential borrowers don’t have the risk appetite; in other words, they are not sufficiently confident of a return.

For governments, directly paying the green premium through subsidies would be hugely expensive. Fortunately, that is not necessary. What is needed is to create conditions in which companies are motivated to invest the money themselves and are rewarded for doing so.

There are good examples of this happening. The automotive industry, particularly in the U.S. and European Union, has invested in the transformational shift to electric vehicles, anticipating a near future in which manufacturers will not be allowed to sell vehicles powered by internal combustion engines. And the U.S. government’s Inflation Reduction Act has been described by the World Economic Forum as “a compelling nudge” to the private sector and investors to decarbonize hard-to-abate sectors.

In the U.S., the approach has been to rely heavily on incentives — the proverbial carrot — which means that companies’ participation is voluntary. This reflects what is politically most feasible in the U.S.: It is hard to impose constraints on business, especially at a federal level, in a culture that reveres free enterprise. Incentives are targeted at strengthening the technology leadership of the U.S. economy, playing to a nationalist and environmental agenda. The problem: The incentives needed to kick-start investment in some industries might be very high and might depend in practice on enabling initiatives that cannot be solved with money alone, such as issuing permits to build new long-distance grids for wind and solar power.

The EU, in contrast, relies principally on regulation — the proverbial stick. This reflects what is politically most feasible; it is hard to offer incentives at the EU level without favoring national target industries and getting into divisive politics. But regulation is unifying and has been the core of the EU’s supranational toolkit. It uses the EU’s market power, a market too big for global players to miss out on. The problem: It might impose unquantified and hidden costs on industry without first gaining political acceptance of that outcome. That is the background to Germany’s recent wobble about protecting its internal-combustion-based car industry from the forced move to electric vehicles.

The Power of an Industrial Strategy

America and Europe have hugely different approaches to climate action that reflect their respective self-image and values. Where politics allow, a more balanced mix of sticks and carrots can provide the most effective incentives for companies to progress along their transition pathway. Building up the initiatives in an advertised sequence can provide strong incentives for early action, if companies are confident of the policy environment to come and motivated to position themselves for it.

Such an industrial strategy is not about picking winners and losers but about recognizing and accepting the idea of winners and losers and playing to win — or to not lose. The incentives work by creating risk that companies are motivated to avoid. The financial case for Volkswagen’s early investment in the electric vehicle market sprang in part from the opportunity to win share from its biggest rival, Toyota. The financial case for Toyota’s recent investment in electric vehicles is partly based on defending its market share. Both companies are strongly incentivized by the threat from emerging electric car makers in China. Similarly, carbon capture and storage is expensive and still speculative, but the financial case to industrialize it could be strong for a fossil fuel company concerned about future prohibitions against extracting and selling its mineral assets.

This insight aligns well with the way political power sits largely at the national level (or regional level, in the case of the EU). Governments can stimulate climate action in ways that favor their companies and their economies. The incentives in the Inflation Reduction Act are attracting corporate investment, skilled jobs, and technology innovation to the U.S. Japan’s steelmakers are looking to lead the world in new technology solutions for high-end steel, using hydrogen rather than carbon to reduce iron ore to iron. This battle for competitiveness at both the national and company levels is how we can drive climate action at scale in the short time we have to make an impact.

Creating and Destroying

The transition we are describing is the creative destruction and value migration that have always fueled innovation and investment in a capitalist economy.1 In this important sense, climate change is not a collective-action problem: For systemwide transformations in which nobody loses, the transition will be practically unaffordable. We need winners and losers — or at least the real prospect of winners and losers — to provide the competitive pressure and financial incentive for companies to act.

The practical task for policy makers is not just to correct for the externalized costs of pollution but to facilitate the dynamic transition to this new state. As researchers have recently asserted, policy makers need to “simultaneously and successfully navigate two distinct but interrelated dynamics: the creation and mass commodification of new green energy technologies on the one hand, and the destruction of powerful, fossil fuel incumbencies on the other.”2

The American and European approaches do not provide this navigation. The carrots of America’s Inflation Reduction Act help to create the new without constraining the old. The sticks of EU’s regulations constrain the old without solving the technological or economic challenge of substituting with the new.

What would a more balanced and dynamic, sequenced approach look like?

Paths to Green Transformation

Japan’s approach to green transformation, or GX, involves a mix of carrots and sticks to drive both parts of the creative destruction required, sequenced over time. The explicit goal is to deliver “both emissions reduction and economic growth,” without sacrificing either. At the highest level, Japanese corporate and government interests are aligned: “The success or failure of GX initiatives is directly linked to the competitiveness of companies and nations.”

The immediate carrot is the commitment of 20 trillion yen ($140 billion) of government support for upfront investment over the next 10 years and an envisaged 150 trillion yen of public and private investment. The principal stick is an industrial pricing mechanism for carbon that is in trials now and expected to be phased in starting in 2026. The plan includes both a European-style emissions-trading scheme for high-emissions industries and a surcharge on the supply of fossil fuels.

Announcing the stick now but phasing it in later in the decade creates the immediate incentive for companies to make the technology investments in their transitions, without penalizing them financially before they have had the opportunity to adapt.

Japanese companies are partners in this effort as well as counterparties. The intent is not just to reduce Japan’s own emissions, which account for 3% of the world’s total, but to position Japanese companies as service providers helping to reduce other countries’ emissions too, through the green technology solutions they will offer.

Companies worked with METI — or with the Ministry of Land, Infrastructure, Transport and Tourism, in the case of maritime transport and aviation — to develop technology road maps for 10 sectors that collectively cover 80% of Japan’s carbon emissions. In the technology road map for iron and steel, for example, the specialist committee advising METI included representation from the Japan Iron and Steel Federation, credit analysts, and the Development Bank of Japan, as well as professors in engineering and technology. The METI road map illustrates its general framework with a specific example, JFE Steel; JFE Steel in turn presents its corporate road map as an application of the METI framework. This collaboration helps companies commit to ambitious transition plans, with the confidence that the government is doing its part in creating the conditions that will make them viable in terms of R&D, energy infrastructure, finance, carbon pricing, and more. The GX plan is as much about enabling these road maps as it is about mandating them.

The plans are not rigid. In the future, different technologies might win out than what today’s plans project. Both government and industry know the technology assumptions that the plans are based on and thus are able to adapt as needed and aren’t locked in. Pluralism is celebrated: The cover image of METI’s strategy document shows multiple paths up a mountain to the 2050 carbon-neutral summit.

Creating the conditions for corporate investments in this way is the role for governments’ industrial strategy, in partnership with sustainable finance. Without such coordinated industrial policies, merely strengthening disclosure requirements on climate-related data and information might increase regulatory burdens unproductively. Government efforts to step up sustainability-related reporting frameworks need to be matched by government actions on the industrial strategy front.